Finance and PM Flashcards
Capital Budgeting – Buy vs. Lease (Finance)
• Calculate NPV of each option and compare to determine which option is cheapest
• NPV of buy option – consider:
o Cost of asset
o PV of tax shield
o Maintenance costs
• NPV of lease option – consider:
o PV of after tax lease payments
• Other factors to consider:
o Impact on covenants
o Cash flows (leasing lessens the current cash burden)
o Leasing may be easier to come by if company has trouble obtaining financing
o Purchasing the asset might provide more flexibility (ownership of asset)
o Leasing might insulate company from severe declines in asset value
o Possible tax advantages (no capital leases for tax purposes – CRA sees all leases the same so cash payments would be deductible, however no CCA)
Financing Options – Debt vs. Equity (Finance)
• Debt financing options:
o Loan- consider loan term, and security/collateral required
o Lease
o Government assistance
• Equity financing options:
o Angel investors- can be friends or family looking for a return on investment; generally passive investors
o Venture capitalists- professional investment funds, looking for superior returns (>30%); active participants in management, with a clear exit strategy
o Private equity- tends to participate later in business lifecycle, hence lower risk
o Public markets
Incremental Cash Flows (Finance)
• Incremental cash flows comprise the additional cash flows from taking on a new project, incorporating the tax-affected initial outlay, annual revenues & expenses and terminal value (or cost) associated with the project, in accordance with the scale and timing of the project
• When determining incremental cash flows from a new project, consider:
o Sunk Costs – These are the initial outlays that cannot be recovered even if a project is accepted. As such, these costs will not affect the future cash flows of the project and are not considered incremental
o Opportunity Costs – These represent any potential loss of current cash flows due to accepting a new project and are considered incremental
o Cannibalization – This is the opportunity cost where a new project takes sales away from an existing product
o Working Capital Changes – These represent changes in receivables, payables and inventory due to accepting a new project and are therefore considered incremental
Net Present Value (NPV) vs. Internal Rate of Return (IRR) (Finance)
- The NPV rule states that you invest in any project which has a positive NPV when its cash flows are discounted at the opportunity cost of capital, also known as the discount rate (usually the cost of raising the capital to fund the project)
- The IRR rule states that you invest in any project offering a rate of return which exceeds the opportunity cost of capital
- A project’s rate of return is calculated as the discount rate at which the NPV of the project would be zero
- Therefore, the NPV and IRR rules should give the same accept/reject answer about a project, in most circumstances
- A project’s cash flows should include incremental elements only (i.e. additional sales, associated expenses, lost margin on cannibalization, investment & associated tax-shield, etc., but no financing elements, as discounting of the cash flows already addresses financing)
Discounted vs. Undiscounted Cash Flows (Finance)
- Incremental cash flows (excluding financing elements) should be discounted to recognize the time value of money for the purposes of making a decision regarding accepting or rejecting a project
- Incremental cash flows (including financing elements) should be analyzed year over year, without discounting, to determine if a certain cash position would be met by a certain time
Payback Period (Finance)
• Payback period is the time in which the initial cash outflow of an investment is expected to be recovered from the cash inflows generated by the investment
• In general, investments with lower payback period are preferred
• To determine, calculate the cumulative net cash flow for each period and then use the following formula for payback period:
Payback Period = A + B / C, where:
A is the last period with a negative cumulative cash flow;
B is the absolute value of cumulative cash flow at the end of the period A; and
C is the total cash flow during the period after A.
Financial Ratio Analysis
Financial Ratio Analysis
Financial ratios are categorized according to the financial aspect that the ratio measures:
• Liquidity ratios measure the availability of cash to pay short-term debts.
E.g., Current ratio, Quick ratio, Working capital ratio
• Asset turnover ratios measure efficiency in utilizing assets. E.g., accounts receivable turnover, inventory turnover
• Profitability ratios measure how well assets are used and expenses are controlled to generate a return. E.g., gross profit margin, net profit
• Debt service ratios measure the ability to repay long-term debt. E.g., debt to equity, times interest earned
Ratios generally are not useful unless they are benchmarked against something else such as past performance or another organization. Therefore, the ratios of organizations in different industries, which face different risks, capital requirements, and competition, are usually hard to compare.
Activity based costing (Management Accounting)
- Costs are allocated to activity cost pools and activity rates are calculated
- Costs that are not driven by activities are not allocated to cost pools
Contribution margin (Finance)
• Contribution margin (CM) is the determination of how much variable profit is available to cover fixed costs and generate a profit.
• In general, the higher CM, the better.
• To determine CM, calculate the variable revenues per unit (hour, day, year, quantity) offset by the variable costs of the same.
• CM is A – B where:
A is the total variable revenue per unit;
B is the total variable expenses per unit.
Break-even analysis (Finance)
• Break-even is the determination of sales volumes necessary to generate a zero-profit.
• Break-even can be expressed in number of units, total revenues, or a percentage of expected revenues.
• To determine, calculate the fixed costs per period, and divide them by the contribution margin (CM) per unit, to determine the necessary sales volumes to generate zero-profit.
• Break-even is A / B where:
A is the total fixed costs;
B is the CM per unit.
Performance measurement of responsibility centres
• A responsibility accounting system can improve goal congruence by assigning decision-making rights to responsibility centres, which are then held accountable for achieving organizational goals.
• Common types of responsibility centres are:
o Revenue – e.g., actual vs. budgeted revenue, revenue growth
o Cost centre – e.g., actual vs. budgeted costs, cost per unit
o Profit centre – e.g., actual vs. budgeted profit, growth in net income
o Investment centre – e.g., return on assets, growth in return on assets
Key performance measures (for-profit)
Balanced Score Card
Key performance measures (for-profit)
For-profit performance indicators can be grouped into five key areas:
• Financial indicators – revenue growth, productivity, asset utilization
• Customer indicators – customer selection, customer acquisition, customer service and retention, customer growth
• Internal business process indicators – supplier management, production management, distribution management
• Learning and growth indicators – innovation, human capital, information capital
• Regulatory indicators – environmental observance, legal compliance, community observance
External analysis – Porter’s Five Forces
The key considerations in Porter’s Five Forces include:
• Bargaining power of buyers, considering
o Concentration of buyers
o Ability to purchase from another supplier
• Bargaining power of suppliers
o Are there many or few suppliers?
o How costly is it to switch suppliers?
• Threat of substitution
o Are there readily available substitutes?
• Threat of new entrants
o Consider barriers to entry – economies of scale, product branding, capital requirements, government policies
• Competitive rivalry
o Consider – number of competitors, industry growth, unutilized capacity, exit barriers, etc.
External analysis – SWOT Analysis
SWOT Analysis (Strengths Weaknesses, Opportunities, and Threats) scans the internal and external environments to provide a comprehensive understanding of the business context.
A SWOT Analysis is designed to tell us where
• external opportunities potentially align with organizational strengths and vice versa,
• where threats loom and
• where we lack competence.
A SWOT Analysis can also help us identify the strategic drivers of the business. With this understanding, you can have more confidence during strategy development.
Governance structures
Organizations will have different corporate governance practices depending on:
• Their size (e.g., number of directors, the number of committees);
• Ownership structure (e.g., privately owned or publicly held);
• Nature, scope and complexity of operations (e.g., individuals with relevant expertise).
